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Investments, 8th edition
Bodie, Kane and Marcus
Slides by Susan Hine
McGraw-Hill/Irwin Copyright © 2009 by The McGraw-Hill Companies, Inc. All rights reserved.
CHAPTER 1 The Investment
Environment
1-2
Real Assets Versus Financial Assets
• Essential nature of investment
– Reduced current consumption
– Planned later consumption
• Real Assets
– Assets used to produce goods and
services
• Financial Assets
– Claims on real assets
1-5
A Taxonomy of Financial Assets
• Fixed income or debt
– Money market instruments
• Bank certificates of deposit
– Capital market instruments
• Bonds
• Common stock or equity
• Derivative securities
1-6
Financial Markets and the Economy
• Information Role
– The Google effect
• Consumption Timing
• Allocation of Risk
• Separation of Ownership and
Management
– Agency Issues
1-7
Financial Markets and the
Economy Continued
• Corporate Governance and Corporate Ethics
– Accounting Scandals
• Examples – Enron, Rite Aid, HealthSouth
– Auditors—watchdogs of the firms
– Analyst Scandals
• Arthur Andersen
– Sarbanes-Oxley Act
• Tighten the rules of corporate governance
1-8
The Investment Process
• Asset allocation
– Choice among broad asset classes
• Security selection
– Choice of which securities to hold within
asset class
• Security analysis
1-9
Markets are Competitive
• Risk-Return Trade-Off
• Efficient Markets
– Active Management
• Finding mispriced securities
• Timing the market
– Passive Management
• No attempt to find undervalued
securities
• No attempt to time the market
• Holding a highly diversified portfolio
1-10
The Players
• Business Firms– net borrowers
• Households – net savers
• Governments – can be both borrowers and
savers
• Financial Intermediaries
– Investment Companies
– Banks
– Insurance companies
– Credit unions
1-11
The Players Continued
• Investment Bankers
– Perform specialized services for
businesses
– Markets in the primary market
1-14
Recent Trends—Globalization
• American Depository Receipts (ADRs)
• Foreign securities offered in dollars
• Mutual funds that invest internationally
• Instruments and vehicles continue to
develop (WEBs)
• Exchange Traded Funds (ETFs)
1-16
Recent Trends—Securitization
• Mortgage pass-through securities
• Other pass-through arrangements
– Car, student, home equity, credit card
loans
• Offers opportunities for investors and
originators
1-18
Recent Trends—Financial Engineering
• Use of mathematical models and computer-
based trading technology to synthesize new
financial products
• Bundling and unbundling of cash flows
1-21
Recent Trends—Computer Networks
• Online information dissemination
• Information is made cheaply and widely
available to the public
• Automated trade crossing
– Direct trading among investors
Investments, 8th edition
Bodie, Kane and Marcus
Slides by Susan Hine
McGraw-Hill/Irwin Copyright © 2009 by The McGraw-Hill Companies, Inc. All rights reserved.
CHAPTER 2 Asset Classes and Financial Instruments
1-23
Major Classes of Financial Assets or
Securities
• Money market
• Bond market
• Equity Securities
• Indexes
• Derivative markets
1-24
The Money Market
• Treasury bills
– Bid and asked price
– Bank discount method
• Certificates of Deposits
• Commercial Paper
• Bankers Acceptances
1-25
The Money Market Continued
• Eurodollars
• Repurchase Agreements (RPs) and Reverse
RPs
• Brokers’ Calls
• Federal Funds
• LIBOR Market
1-30
The Bond Market
• Treasury Notes and Bonds
• Inflation-Protected Treasury Bonds
• Federal Agency Debt
• International Bonds
• Municipal Bonds
• Corporate Bonds
• Mortgages and Mortgage-Backed Securities
1-31
Treasury Notes and Bonds
• Maturities
– Notes – maturities up to 10 years
– Bonds – maturities in excess of 10 years
– 30-year bond
• Par Value - $1,000
• Quotes – percentage of par
1-33
Federal Agency Debt
• Major issuers
– Federal Home Loan Bank
– Federal National Mortgage Association
– Government National Mortgage
Association
– Federal Home Loan Mortgage Corporation
1-34
Municipal Bonds
• Issued by state and local governments
• Types
– General obligation bonds
– Revenue bonds
• Industrial revenue bonds
• Maturities – range up to 30 years
1-36
Municipal Bond Yields
• Interest income on municipal bonds is not
subject to federal and sometimes not to state
and local tax
• To compare yields on taxable securities a
Taxable Equivalent Yield is constructed
1-39
Corporate Bonds
• Issued by private firms
• Semi-annual interest payments
• Subject to larger default risk than government
securities
• Options in corporate bonds
– Callable
– Convertible
1-40
• Developed in the 1970s to help liquidity of
financial institutions
• Proportional ownership of a pool or a
specified obligation secured by a pool
• Market has experienced very high rates of
growth
Mortgages and Mortgage-Backed
Securities
1-42
Equity Securities
• Common stock
– Residual claim
– Limited liability
• Preferred stock
– Fixed dividends -limited
– Priority over common
– Tax treatment
• Depository receipts
1-44
• There are several broadly based indexes
computed and published daily
• There are several indexes of bond market
performance
• Others include:
– Nikkei Average
– Financial Times Index
Stock Market Indexes
1-45
Dow Jones Industrial Average
• Includes 30 large blue-chip corporations
• Computed since 1896
• Price-weighted average
1-46
Example 2.2 Price-Weighted Average
Portfolio: Initial value $25 + $100 = $125
Final value $30 + $ 90 = $120
Percentage change in portfolio value
= 5/125 = -.04 = -4%
Index: Initial index value (25+100)/2 = 62.5
Final index value (30 + 90)/2 = 60
Percentage change in index -2.5/62.5
= -.04 = -4%
1-47
• Broadly based index of 500 firms
• Market-value-weighted index
• Index funds
• Exchange Traded Funds (ETFs)
Standard & Poor’s Indexes
1-50
Foreign and International
Stock Market Indexes
• Nikkei (Japan)
• FTSE (Financial Times of London)
• Dax (Germany)
• MSCI (Morgan Stanley Capital International)
• Hang Seng (Hong Kong)
• TSX (Canada)
1-51
Derivatives Markets
Options
• Basic Positions
– Call (Buy)
– Put (Sell)
• Terms
– Exercise Price
– Expiration Date
– Assets
Futures
• Basic Positions
– Long (Buy)
– Short (Sell)
• Terms
– Delivery Date
– Assets
Investments, 8th edition
Bodie, Kane and Marcus
Slides by Susan Hine
McGraw-Hill/Irwin Copyright © 2009 by The McGraw-Hill Companies, Inc. All rights reserved.
CHAPTER 3 How Securities
are Traded
1-55
How Firms Issue Securities
• Primary
– New issue
– Key factor: issuer receives the proceeds
from the sale
• Secondary
– Existing owner sells to another party
– Issuing firm doesn’t receive proceeds
and is not directly involved
1-56
How Firms Issue Securities Continued
• Investment Banking
• Shelf Registration
• Private Placements
• Initial Public Offerings (IPOs)
1-57
Investment Banking
• Underwritten: firm commitment on proceeds
to the issuing firm
• Red herring
• Prospectus
1-60
• Sale to a limited number of sophisticated
investors not requiring the protection of
registration
• Allowed under Rule 144A
• Dominated by institutions
• Very active market for debt securities
• Not active for stock offerings
Private Placements
1-61
Initial Public Offerings
• Process
– Road shows
– Bookbuilding
• Underpricing
– Post sale returns
– Cost to the issuing firm
1-64
How Securities are Traded
• Types of Markets
– Direct search
• Least organized
– Brokered
• Trading in a good is active
– Dealer
• Trading in a particular type of asset increases
– Auction
• Most integrated
1-65
Types of Orders
• Market—executed immediately
– Bid Price
– Ask Price
• Price-contingent
– Investors specify prices
– Stop orders
1-68
Trading Mechanisms
• Dealer markets
• Electronic communication networks (ECNs)
• Specialists markets
1-69
U.S. Security Markets
• Nasdaq and NYSE have evolved in response
to new information technology
• Both have increased their commitment to
automated electronic trading
1-70
Nasdaq
• National Market System
• Nasdaq Small Cap Market
• Levels of subscribers
– Level 1 – inside quotes
– Level 2 – receives all quotes but they can’t
enter quotes
– Level 3 – dealers making markets
1-72
New York Stock Exchange
• Member functions
– Commission brokers
– Floor brokers
– Specialists
• Block houses
• SuperDot
1-75
Other Systems
• Electronic Communication Networks
– Private computer networks that directly link
buyers with sellers
• National Market System
– Securities Act of Amendments of 1975
• Bond Trading
– Automated Bond System (ABS)
1-76
Market Structure in Other Countries
• London - predominately electronic trading
• Euronext – market formed by combination of
the Paris, Amsterdam and Brussels
exchanges
• Tokyo Stock Exchange
• Globalization and consolidation of stock
markets
1-78
Trading Costs
• Commission: fee paid to broker for making
the transaction
• Spread: cost of trading with dealer
– Bid: price dealer will buy from you
– Ask: price dealer will sell to you
– Spread: ask - bid
• Combination: on some trades both are paid
1-79
Buying on Margin
• Using only a portion of the proceeds for an
investment
• Borrow remaining component
• Margin arrangements differ for stocks and
futures
1-80
Stock Margin Trading
• Margin is currently 50%; you can borrow up to
50% of the stock value
– Set by the Fed
• Maintenance margin: minimum amount equity
in trading can be before additional funds must
be put into the account
• Margin call: notification from broker that you
must put up additional funds
1-81
Margin Trading - Initial Conditions
Example 3.1
X Corp $100
60% Initial Margin
40% Maintenance Margin
100 Shares Purchased
Initial Position
Stock $10,000 Borrowed $4,000
Equity $6,000
1-82
Margin Trading - Maintenance Margin
Example 3.1
Stock price falls to $70 per share
New Position
Stock $7,000 Borrowed $4,000
Equity $3,000
Margin% = $3,000/$7,000 = 43%
1-83
Margin Trading - Margin Call Example 3.2
How far can the stock price fall before a
margin call?
(100P - $4,000)* / 100P = 30%
P = $57.14
* 100P - Amt Borrowed = Equity
1-85
Short Sales
• Purpose: to profit from a decline in the price of a stock or security
• Mechanics
– Borrow stock through a dealer
– Sell it and deposit proceeds and margin in an account
– Closing out the position: buy the stock and return to the party from which is was borrowed
1-86
Short Sale – Initial Conditions Example 3.3
Dot Bomb 1,000 Shares
50% Initial Margin
30% Maintenance Margin
$100 Initial Price
Sale Proceeds $100,000
Margin & Equity 50,000
Stock Owed 100,000
1-87
Short Sale - Maintenance Margin
Stock Price Rises to $110
Sale Proceeds $10,000
Initial Margin 5,000
Stock Owed 11,000
Net Equity 4,000
Margin % (4000/11,000) 36%
1-88
Short Sale - Margin Call
How much can the stock price rise before a
margin call?
($150,000* - 1000P) / (100P) = 30%
P = $115.38
* Initial margin plus sale proceeds
1-89
Regulation of Securities Markets
• Major regulations
– Securities Act of 1933
– Securities Act of 1934
– Securities Investor Protection Act of 1970
• Self-Regulation
– Stock markets are largely self-regulating
1-90
Regulation Securities Markets Continued
• Regulatory Responses to Recent Scandals
– Public Company Accounting Oversight
Board
– Financial experts to serve on audit
committees of boards of directors
– CEOs and CFOs personally certify firms’
financial reports
– Boards must have independent directors
– Sarbanes-Oxley Act
1-92
Insider Trading
• Officers, directors, major stockholders must
report all transactions in firm’s stock
• Insiders do exploit their knowledge
• Leakage of useful information to some
traders
Investments, 8th edition
Bodie, Kane and Marcus
Slides by Susan Hine
McGraw-Hill/Irwin Copyright © 2009 by The McGraw-Hill Companies, Inc. All rights reserved.
CHAPTER 4 Mutual Funds
and Other
Investment
Companies
1-94
Investment Companies
• These companies perform several
important functions for investors:
– Administration & record keeping
– Diversification & divisibility
– Professional management
– Reduced transaction costs
1-95
Net Asset Value
• Used as a basis for valuation of investment
company shares
– Selling new shares
– Redeeming existing shares
Calculation
Market Value of Assets - Liabilities
Shares Outstanding
1-96
Types of Investment Companies
• Unit Trusts
• Managed Investment Companies
– Open-End
• Open-end: shares outstanding change when new shares are sold or old shares are redeemed
• Priced at Net Asset Value(NAV)
– Closed-End
• no change in shares outstanding unless new stock is offered
• Priced at Premium or discount to NAV
1-98
Types of Investment
Companies Continued
• Other investment organizations
– Commingled funds
– REITs
– Hedge Funds
1-99
Mutual Funds—Investment Policies
• Money Market
• Equity
• Sector
• Bond
• Balanced
• Asset Allocation and Flexible
• Index
• International
1-101
How Funds Are Sold
• Direct-marketed funds
• Sales force distributed
• Revenue sharing on sales force distributed
– Potential conflicts of interest
• Financial Supermarkets
1-102
Costs of Investing in Mutual Funds
• Fee Structure
– Operating expenses
– Front-end load
– Back-end load
– 12 b-1 charges
• distribution costs paid by the fund
• Alternative to a load
1-103
Fees and Mutual Fund Returns
1 0
0
NAV NAV Income and capital gain distributionsRate of return =
NAV
0
10
20
30
40
50
60
70
80
90
1st Qtr 2nd Qtr 3rd Qtr 4th Qtr
East
West
North
1-104
Fees and Mutual Fund Returns:
An Example
Initial NAV = $20
Income distributions of $.15
Capital gain distributions of $.05
Ending NAV = $20.10:
$20.10 - $20.00 + $.15 + $.05Rate of Return = 1.5%
$20.00
1-106
Trading Scandal with Mutual Funds
• Late trading – allowing some investors to
purchase or sell later than other investors
• Market timing – allowing investors to buy or
sell on stale net asset values
– International
• Net effect is to transfer value from other
shareholders to privileged traders
– Reduction in the rate of return of the
mutual fund
1-107
Potential Reforms
• Strict 4:00 PM cutoff with late orders
executed the following trading day
• Fair value pricing with net asset values being
adjusted for trading in open markets
• Imposition of redemption fees
1-108
Taxation on Mutual Fund Income
• Pass-through status under the U.S. tax code
– Taxes are paid only by the investor
• High turnover leads to tax inefficiency
1-109
Exchange Traded Funds
• ETF allow investors to trade index portfolios like shares of stock
• Examples - SPDRs and WEBS
• Potential advantages
– Lower taxes
– Trade continuously
– Lower costs
• Potential disadvantages
– Prices can depart by small amounts from NAV
1-111
Mutual Fund Investment Performance:
A First Look
• Evidence shows that average mutual fund
performance is generally less than broad
market performance
• Evidence that performance is consistent from
one period to the next is suggestive but
inconclusive
1-114
Information on Mutual Funds
• Wiesenberger’s Investment Companies
• Morningstar (www.morningstar.com)
• Yahoo (biz.yahoo.com/funds)
• Investment Company Institute (www.ici.org)
• Directory of Mutual Funds
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